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Basel Committee

on Banking Supervision

Peer review of supervisoryauthorities implementation ofstress testing principles

April 2012

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Copies of publications are available from:

Bank for International SettlementsCommunicationsCH-4002 Basel, Switzerland

E-mail: [email protected]

Fax: +41 61 280 9100 a nd +41 61 280 8100

This publication is available on the BIS website ( www.bis.org ).

Bank for International Settlements 2012. All rights reserved. Brief excerpts may be reproduced or translated provided the source is stated.

ISBN print: 92-9131-111-1ISBN web: 92-9197-111-1
mailto:[email protected]:[email protected]

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Contents

Executive summary ........................ ............................. ............................ ............................ .....1

The global financial crisis and the 2009 stress testing principles ........................ .....................1

Scope of the review .......................... ............................ ............................ ................................1

Key findings ........................... ............................ ............................. ............................ ..............2

Progress overview...........................................................................................................2

Remaining challenges and examples of good practices ......................... ........................2

1. Introduction......................................................................................................................4

2. Methodology....................................................................................................................4

3. Assessment of principles for supervisors ......................... ............................. ..................5

3.1 Overall maturity of implementation.............. ............................. ..............................5

3.2 Prudential framework ......................... ............................ ............................ ............6

3.3 Supervisory review........ .............................. ............................. ..............................6

3.4 Supervisory action.............................. ............................ ............................ ............7

3.5 Supervisory resourcing ............................ ............................ ............................ ......8

3.6 Supervisory stress testing......................... ............................ ............................ .....8

3.7 Supervisory assessment and challenge...................................... ...........................9

3.8 Dialogue with public and private sectors..............................................................10

3.9 Effective supervisory approaches ........................... ............................ .................10

3.10 Future plans ......................... ............................ ............................. .......................11

4. Principles for Banks.......................................................................................................11

5. Conclusions...................................................................................................................12

Annex 1..................................... ............................ ............................. .....................................15

Annex 2..................................... ............................ ............................. .....................................17

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Executive summary

This report summarises the Basel Committees peer review on how supervisory authoritieshave implemented the Committees 2009 Principles for sound stress testing practices andsupervision 1 .

The global financial crisis and the 2009 stress testing principles

Stress testing is an important tool for banks to identify unexpected adverse outcomes acrossa range of risks. It plays a particularly important role in:

providing forward-looking assessments of risk;

overcoming limitations of models and historical data;

supporting internal and external communication; feeding into capital and liquidity planning procedures;

informing the setting of banks risk tolerance; and

facilitating the development of risk mitigation or contingency plans across a range ofstressed conditions.

In 2009, the Committee reviewed the performance of stress testing practices during the crisisand found weaknesses in various areas. Based on the findings, and as part of its efforts toincorporate lessons from the crisis in supervisory practices, the Committee publishedrecommendations for banks and supervisors entitled Principles for sound stress testing

practices and supervision .

The guidance sets out a comprehensive set of principles for the sound governance, designand implementation of stress testing programmes at banks. The principles also establishedhigh-level expectations for the role and responsibilities of supervisors in evaluating stresstesting practices.

Scope of the review

As part of its mandate to assess the implementation of standards across countries, during2011 the Committee's Standards Implementation Group undertook a peer review of

supervisory authorities implementation of the principles.

The review was conducted via an off-site survey of supervisory authorities. All Committeemember countries and one non-member country participated in the review. 2 The reviewfocused primarily on progress in supervisory processes used to implement the principles. It

1 Available at www.bis.org/publ/bcbs155.htm.2 The Basel Committee on Banking Supervision consists of senior representatives of bank supervisory

authorities and central banks from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany,Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi

Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the UnitedStates. In addition, Thailand participated in this exercise.

Peer review of supervisory authorities implementation of stress testing principles 1
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was not designed to provide a detailed country-by-country assessment or to assess theadequacy of banks' stress testing programmes.

Increasingly, supervisory stress tests are being used to set minimum capital requirements,determine explicit capital buffers or to limit capital distributions by banks. This recentdevelopment was not extensively considered in the principles and as a result was not a keyfocus of the review.

Key findings

Progress overview

In the period since the principles were issued, stress testing has become a key component ofthe supervisory assessment process as well as a tool for contingency planning andcommunication. Many of the countries participating in this peer review have been working toimplement and refine stress testing frameworks and methodologies at the same time as their

economies and banking systems have been affected by a high degree of global economicand financial uncertainty. Although many supervisory authorities and banks had operationalstress testing frameworks in place, existing guidance and rules had to be revised and newexpectations put in place to broaden and deepen stress testing capabilities at both banksand supervisory authorities.

The review found that countries are at varying stages of maturity in their implementation ofthe principles. Nearly half of the countries were considered to be at an early stage. Thesecountries showed some progress toward implementing the principles, but they may not haveissued or finalised prudential requirements on enterprise-wide stress testing since theprinciples were published. They generally had not conducted regular on-site or off-sitereviews other than in the context of risk-specific modelling requirements such as for market

risk, and had conducted industry-wide stress tests infrequently, or only as part ofInternational Monetary Fund Financial Sector Assessment Program (FSAP) reviews.

In contrast, a few countries were considered to be advanced. For these countries, the surveyresponses provided evidence of a rigorous regular review process that included acombination of on-site and off-site assessments, some review and feedback on detailedstress testing models used by banks, evidence of follow-up actions and a well-embeddedsupervisory stress testing programme that was not limited to externally imposed scenarios.

The remainder of countries were found to fall between the above two groups. Thesecountries have issued some formal requirements or guidance consistent with the principles,are generally performing regular supervisory stress tests on large banks in their jurisdictions

and are reviewing stress testing in the context of annual internal capital adequacyassessment process (ICAAP) reviews and specific risk reviews. These countries have moreto do in deepening their stress testing programmes, including issuing updated requirementsand conducting more detailed on-site and off-site reviews of banks' stress testing capabilities.

Remaining challenges and examples of good practices

The most common o verall supervisory approach was to conduct some review of banks'stress testing as part of regular ICAAP assessments and in the context of specific riskswhere ongoing supervisory review of exposure modelling is now routine, notably market andliquidity risks. Conducting more detailed, comprehensive reviews of banks' enterprise-widestress testing governance and modelling as envisioned in the principles requires expert skillsand resourcing at both banks and supervisors, and as a result has not yet become standardpractice in many countries.

2 Peer review of supervisory authorities implementation of stress testing principles

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A significant development in the last several years has been the increased use ofsupervisory stress tests. A majority of countries now regularly conduct mandated stress testswith prescribed scenarios across the large banks in their jurisdictions, although for somecountries, this is limited to the FSAP stress tests.

A number of countries noted the resource-intensive nature of industry-wide stress tests. Inparticular, the more advanced countries note that resourcing at both supervisory authoritiesand banks to support stress testing is challenging, with a trend towards establishing speciallystaffed units or internal task forces for stress testing. Many, however, found that theseexercises have been helpful in terms of enhancing the visibility of stress testing and providinga structured basis for dialogue with banks on their capabilities. It was noted that industrydialogue around mandated stress tests had led to improvements in bank capabilities.

The following types of practices are also associated with relatively more advanced countries:

plans for, or completed horizontal or thematic reviews of, stress testing either at anenterprise-wide level or for specific portfolios;

engagement with boards of directors on stress testing scenarios and governance; review of detailed evidence of how banks are using stress test outcomes in their

decision-making and risk-appetite setting;

well-articulated plans for improving their stress testing supervision programmes;

involvement of both generalist and specialist supervision staff; and

publication of the results and provision of consistent feedback to banks.

While not a primary focus of the peer review, many countries provided views on areas forimprovement in stress testing practices at banks. These responses focused fairlyconsistently on areas such as governance and the use of stress testing in bank decision-

making, data and information technology infrastructure, severity of scenarios and firm-widemodelling challenges.

The review found the principles to be generally effective. The Committee, however, willcontinue to monitor implementation of the principles and determine whether, in the future,additional guidance might be necessary.


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1. Introduction

Stress testing is an important tool for banks to identify unexpected adverse outcomes acrossa range of risks. The financial crisis highlighted significant weaknesses in banks' stresstesting programmes that contributed to failures to identify the nature and magnitude of keyrisks. As a result, the Committee engaged with the industry in examining stress testingpractices and, in May 2009, the Committee published recommendations for banks andsupervisors entitled Principles for sound stress testing practices and supervision .

The guidance set out a comprehensive set of principles for the sound governance, designand implementation of stress testing programmes at banks. The principles establishedexpectations for the role and responsibilities of supervisors in evaluating stress testingpractices. Overall, the guidance includes fifteen principles for banks and six principles forsupervisors (see Annex 1).

As part of its mandate to assess the implementation of its standards across countries, theCommittee's Standards Implementation Group undertook a peer review of supervisory

authorities implementation of the principles. The objectives of this review were to:

assess the extent to which the principles have been implemented in a rigorous andconsistent manner across the Committee's member authorities;

identify and provide feedback on factors that are most critical to the effectiveimplementation of the principles; and

assess the effectiveness of the principles themselves.

An important element of the review was the context in which the principles are beingimplemented. Many of the countries participating in this peer review have been working toimplement and refine stress testing frameworks and methodologies at the same time theireconomies and banking systems have been affected by a high degree of global economicand financial uncertainty. Although many supervisory authorities and banks had operationalstress testing frameworks in place, existing guidance and rules had to be revised and newexpectations put in place to broaden and deepen stress testing capabilities at both banksand supervisors. This is being done in a stressed environment and is also being conductedat a time when stress testing infrastructure, including the ability to collect appropriate data,develop models and aggregate results, is evolving.

As a result, the current environment has provided a useful early test of how countries areputting the principles into practice. More broadly, it was evident that countries areimplementing stress testing regimes and activities in different ways that may reflect theirindividual situations and not all will follow the same progression or path in implementing the

principles. The review was intended to deliver feedback on good supervisory practice to helpsupervisors implement standards more effectively. Indeed, several countries have reportedsignificant progress subsequent to the completion of the peer review survey, particularly withregard to supervisory stress testing practices.

2. Methodology

The peer review was conducted through a questionnaire which was distributed to Committeemember countries in September 2011. Analysis of the responses was conducted by aworking group of representatives of supervisory authorities with expertise in stress testing.The questionnaire focused primarily on the implementation activities of supervisors andconsisted of both factual multiple choice questions and free-form responses.

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The review team used the information provided by each country and, where relevant, sourcedocuments demonstrating its implementation of the principles, to assess and compare theprogress made across countries. Given the off-site and high-level nature of the review, it wasnot intended to produce a definitive assessment of individual countries' implementation of theprinciples, but, rather, to allow an overall view of progress across countries. A detailed reportwas provided to the Standards Implementation Group and to the Committee.

The review focused primarily on the implementation of principles 16-21 for supervisors, as itwas not within the scope of the peer review to assess compliance by banks with principles 1-15 on stress testing practices. However, countries were invited to provide their views on theease and effectiveness of implementation for each of the principles for banks in their

jurisdiction. In their responses, supervisory authorities were asked to focus on supervision ofthe largest banks in their jurisdiction, although some also addressed their supervisoryexpectations for stress testing at smaller banks.

3. Assessment of principles for supervisors

3.1 Overall maturity of implementation

For purposes of assessing and comparing implementation of the principles, participatingcountries were stratified as being in an early , intermediate or advanced state ofimplementation. These assessments were based on indicators of maturity developed for thispurpose by the review team (Annex 2), as well as the quality and thoroughness of thequestionnaire responses.

Countries in the early category (nearly half of respondents) showed some progress towardsimplementing the principles; however, they may not have issued or finalised prudentialrequirements on enterprise-wide stress testing since the principles were published. These

countries generally had not conducted regular on-site or off-site reviews other than in thecontext of risk-specific modelling requirements such as for market risk, and have conductedindustry-wide stress tests infrequently, or only as part of FSAP reviews.

In contrast, a few countries were classified as advanced . For these countries, the reviewteam saw evidence of a rigorous regular review process that included a combination of:

on-site and off-site assessments;

some review and feedback on detailed stress testing models used by banks;

evidence of follow-up actions; and

a well-embedded supervisory stress testing programme that was not limited toFSAP or regionally-imposed scenarios.

The remainder of countries (approximately half of respondents) fell into the intermediate category. These countries have issued some formal requirements or guidance consistentwith the principles, were generally performing regular supervisory stress tests on their largebanks and were reviewing stress testing in the context of annual ICAAP reviews and specificrisk reviews. These countries have more to do in deepening their programmes, includingissuing updated requirements and conducting more detailed on-site and off-site reviews ofbanks' stress testing capabilities. Notably, several countries have reported significantprogress subsequent to the completion of the peer review survey, particularly with regard tosupervisory stress testing practices and also in some cases issuance of stress testingrequirements or guidance.


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Specific areas of supervisory activity in relation to the principles are discussed in more detailbelow.

3.2 Prudential framework

The review found that all countries have in place prudential requirements relating to stress

testing. In many cases these requirements were implemented as a component of Basel II,namely the ICAAP requirements, or otherwise pre-date the principles. In addition, a largemajority of the respondents stated that they had issued specific rules or guidanceimplementing the principles. However, approximately one-third of respondents has notissued any rules or guidance on stress testing post-2009, and thus would not be consideredto have implemented the principles explicitly. These countries rely on other rules relating tostress testing, particularly under the Basel II credit or market risk requirements. In terms offuture plans, a number of countries across different levels of maturity are in the process of, orare planning to strengthen or finalise guidance or regulations.

In some cases, key elements of the principles have been incorporated into the Pillar 2requirements and in other cases as (non-mandatory) guidance for banks. Some countries

issued informal guidance based generally on the principles or on other regional guidelines. Anumber of countries are still in the early phases of issuing prudential expectations forenterprise-wide stress testing. At least a few countries have not yet issued requirementsrelating to Basel II ICAAPs, which was the most common means of implementing theprinciples.

Other countries have already updated their rules and adapted the principles or otherguidelines for their own circumstances. These would be considered to have a more maturesupervision framework for stress testing. A few other countries have issued their own goodpractice guidelines which incorporate the principles as well as key findings from supervisoryactivities and industry dialogue.

Roughly three-quarters of respondents reported that there have not been any impediments toimplementing the principles. However, resourcing and other supervisory priorities were notedas a constraint by a number of other countries.

A number of countries asserted that because their banks or banking systems are notcomplex, some of the aspects of the principles are not relevant (eg structured products andhighly leveraged counterparties). Further, banks in some jurisdictions generally do not havethe infrastructure and skills to be able to comply with sophisticated stress testingrequirements.

3.3 Supervisory review

Principle 16 recommends that supervisors should make regular and comprehensiveassessments of banks' stress testing programmes. The review found that supervisoryauthorities use a combination of on-site and off-site reviews to assess banks stress testingpractices. Most countries indicated that they have conducted some form of on-site review ofstress testing at banks. For specific risk areas (primarily market, liquidity and to some extentcredit risk), there are well established supervisory review programmes.

Almost three-quarters of countries indicated that they perform extensive regular review offirm-wide stress testing practices. The most common approach for assessing firm-wide stresstesting is through annual ICAAP reviews, which generally cover capital planning as well asother matters. Given the scope of ICAAP reviews, it may be difficult to assess all of theprinciples during a routine ICAAP review. Indeed, a few countries indicated that they conducthorizontal or thematic reviews specifically on firm-wide stress testing including the principles,which is considered a more advanced practice.


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The frequency of on-site reviews of firm-wide stress testing varied across countries. Aboutone-third of countries conducted less-than-annual reviews (every 2-4 years) while roughlyhalf of responding countries reported that they conduct annual or more frequent on-sitereviews of stress testing. Some supervisors have conducted a one-time review of theprinciples through self-assessments, questionnaires, or benchmarking studies across arange of banks.

In terms of the scope of supervisory review, supervisory activities regularly covered stresstesting for firm-wide risks, general credit risks, retail mortgages and corporate credit risks,market risk, banking book interest rate risk and liquidity risk. Authorities reported that areassuch as operational risk, overseas operations, as well as specific portfolios such ascommercial property and sovereign risks, receive less coverage.

Supervisory authorities in most countries reported conducting annual or more frequentreview of board and senior management reporting of stress test results. Use of stress testingin loan loss provisioning was reviewed regularly by about half of the countries. The role ofstress testing to help set risk appetite and identify risk concentrations were areas that were

less commonly reviewed; this is an area where supervisory and bank practice is at a veryearly stage. Review of contingency plans for operational risk is the surveyed area least likelyto have been assessed by supervisors in the context of stress testing.

Some countries noted different requirements or expectations of stress testing across banks,mainly depending on the banks systemic importance (including size, complexity andrelevance to economy) and risk profile. Most emphasised that supervisors haveproportionately different expectations when conducting stress testing reviews of smallerbanks. Several countries (particularly those at the more advanced stages of implementationof the principles) indicated that they are planning to increase the expectations of smallerinstitutions with respect to stress testing going forward.

3.4 Supervisory actionPrinciple 17 indicates that supervisors should take action on deficiencies in banks' stresstesting programmes. The review found that the two most common areas for supervisoryfollow-up were improving governance processes for stress testing and use of additional (inparticular, more severe) scenarios. Many countries either regularly or occasionally imposedrequirements to improve data or model validation processes. The least common supervisoryfollow-up action indicated in the responses was to require the bank to review or change limitsor exposures (less than half of the countries reported taking this action regularly).

Principle 19 encourages supervisors to consider the results of stress tests in assessingcapital adequacy and in setting prudential buffers for capital and liquidity. A large majority of

countries indicated that they sometimes or regularly impose capital or liquidity requirementsas a result of stress testing deficiencies. In particular, use of stress scenarios for settingliquidity requirements appears to be fairly well established, particularly as countries worktoward implementing the Basel III liquidity framework, which is based on stressed cash flows.Nearly all of the countries indicated regular review of liquidity stress testing.

Use of stress tests for setting minimum capital requirements, determining explicit capitalbuffers or for limiting capital distributions by banks is a more recent development that wasnot extensively considered in the principles and as a result was not a key focus of the review.

A small number of countries indicated that stress testing has become a key tool for setting orassessing capital requirements. Some countries have issued new requirements in the pastyear or so specifically related to the use of stress tests in assessing capital adequacy. Whileuse of stress tests to set formal minimum capital requirements is not common, use ofstandard supervisory stress scenarios as a benchmarking tool is increasingly prevalent.


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Other countries took the view that stress test results are just one factor in assessing howmuch capital is needed to offset the risk of unexpected losses. In a number of countries, andeven those with fairly advanced stress testing supervision programmes, stress testing wasseen as one of several tools in assessing capital adequacy and there was a reluctance toplace primary reliance on stress test scenario outcomes. This may reflect the evolving natureof supervisory and bank practices.

3.5 Supervisory resourcing

As stress testing is a fairly new and specialised area of supervision, the review found thatresourcing and capabilities for stress testing supervision were key challenges for manysupervisory authorities. Only a few countries have established units specifically dedicated tostress testing. Most countries are primarily relying on separate teams of staff to conductsupervisory stress tests and, in many cases, also to review stress testing practices at banks.These teams also perform other tasks in addition to reviewing or conducting stress testing.

Typically, a set of specially trained supervisors is responsible for coordinating with banks withrespect to the collection of data for stress testing and reviewing and consolidating the stresstest information. Often an inter-departmental team is used to conduct the stress tests. Ingeneral, it was noted that staff with a variety of different backgrounds can be useful in stresstesting, including macro-surveillance economists, risk specialists and modelling experts, aswell as generalist supervisors who are most familiar with individual institutions or accountingexperts.

Similarly, most countries utilise both risk specialists and generalist supervisors in reviewingstress testing practices at banks. In most countries, generalist supervisors are involved in thereview of stress testing practices; however, they are not generally involved in conductingsupervisory stress tests. At the same time, some countries noted that where stress testing isallocated to a separate unit, it can be more difficult to ensure that stress testing is embedded

within routine supervision and that stress test outcomes are understood and used by thegeneralist supervisors. This was seen as an evolving challenge.

The more advanced countries, in particular, noted a general lack of specialised stress testingresources. Indeed, some countries found that prioritisation of supervisory work is a majorissue as key individuals involved often have other responsibilities.

Most countries indicated they had established some form of training programme on stresstesting for supervisors. In many cases, the training was of a quite general nature and in somecases limited to presentation of the results of supervisory stress tests or high-level discussionin the context of introductory training on Pillar 2 approaches. A few countries provide quiteadvanced training programmes, including case studies, and some offer training to other

countries' supervisors or to banks in their jurisdiction. Not surprisingly, several countriesnoted that stress testing training is an area of focus in their future plans.

3.6 Supervisory stress testing

Principle 2 0 recommends that supervisors should consider implementing stress testexercises based on common scenarios. It is clear that there has been a significant increasein the use of supervisory stress tests in recent years. In fact, all countries indicated that theyconduct some form of supervisory stress test. As a result, progress in this area can beconsidered more advanced generally than some other aspects of the principles.

Portfolio-level stress tests were reported by more than half of the countries. In recent years,

this has included specific stress tests on, for example, housing loan portfolios, consumerdebt, sovereign risks and liquidity risk. Some countries indicated that they conduct very


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frequent sensitivity testing for specific risks, for example, applying market risk and liquidityshocks on a regular basis.

In terms of firm-wide stress tests based on a common scenario, there was a range ofexperience. A few countries have performed FSAP stress tests only. While these stress testsprovide an important basis and experience for designing supervisory stress tests, in manycases they tended to be led by the FSAP mission team and the national central bank, anddid not have a supervisory focus. About one-third of countries were not running stress testson a firm-wide basis. In a couple of countries, firm-wide stress tests were conducted by the(non-supervisory) central bank, although with some involvement by the supervisory authority.

Many countries conduct both bank-run and supervisor-run stress tests. This can involve thesupervisory authority running the same scenario using supervisory or public data in order tobenchmark banks' results from the bank-run stress test. Some countries run both regionaland country-specific stress tests.

Directing banks to run a stress test using a common scenario is considered to be a moreadvanced practice for supervisors, as it requires more detailed understanding of bankmodelling capabilities and an ability to assess the results. About half of the countries haveconducted bank-run, firm-wide stress tests (outside of the FSAP process), of which abouthalf conduct these on an annual basis.

3.7 Supervisory assessment and challenge

The overall assessment and challenge of the reasonableness of banks' stress test scenariosand outputs is a difficult area for supervision. In many countries, the models, assumptionsand approaches used are evolving, and banks are at varying degrees of sophistication.

At a general level, the review found a range of supervisory methods for challenging the

scope and results of banks stress tests and scenarios. The most widely used method was tocompare outputs with historical experience, such as a past severe recession. However, incountries with little history of financial crisis, this approach may be more difficult.

A number of countries conducted their own parallel stress tests on bank financial data tobenchmark results produced by banks or placed high reliance on reasonableness checksbased on supervisors understanding of portfolios. Peer comparisons were very useful incountries where banks subject to stress testing are comparable in size and scope. Somecountries facilitate this by requiring banks to report the results of their stress tests in astandardised manner. A number of countries also place moderate to high reliance on banks'own internal model validation reporting.

Independent review by external auditors or consultants can be one element of theassessment and challenge process for some countries. But more than half of countriesindicated they do not rely at all on independent review of stress testing results as part of theirsupervision activities.

Another supervisory trend is that supervisory authorities are more actively reviewingscenarios chosen by the banks in their internal stress testing and, for example, the banksICAAPs. Monitoring or keeping a systematic inventory of scenarios used by banks is a moreadvanced practice as it allows better benchmarking of peer banks internal view of stressedconditions and possible vulnerabilities.

Several countries maintain a database of scenarios used by their banks, and others have

plans to do this. Over half of the countries periodically review the scenarios used by banks in


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their internal stress testing. A few countries in the earlier stages of maturity were notregularly reviewing scenarios used by banks.

Supervisory authorities in several countries indicated that they have performed reversestress tests, that is, stress tests designed to be sufficiently severe that they challenge theviability of the bank. However, reverse stress testing has not become a common supervisorypractice. In fact, the supervisory stress tests appear to be the vehicle for assessing theimpact of more severe scenarios. In terms of the choice of scenario for supervisory stresstests, the most common approach was to look to a previous severe recession or input fromthe central bank. Also very common was to target the scenario to known vulnerabilities.

About half of the countries have used externally prescribed scenarios (for example, from aregional authority or FSAP process).

3.8 Dialogue with public and private sectors

Stress testing is increasingly part of the public debate on the strength and transparency ofsupervision. Supervisory authorities have regular discussions with banking industry riskofficers or hold occasional seminars, workshops or roundtables with banks to exchangeexperiences on stress testing methodologies and use of results. In some cases, this hasresulted in publication of local industry guidance based on the Committee's principles.

Some supervisors also have a formal process for coordinating with other officialorganisations within their country. In some cases, a formal committee of regulators and otherauthorities (including the central bank) discusses systemic vulnerabilities and provides inputinto stress testing programmes and the scenarios to be tested. A number of othersupervisors coordinate with their central bank in conducting a quantitative macroeconomicstress test, including consideration of potential systemic issues that may be caused bybanks management reactions to a common stress scenario. Regional-level coordinatingbodies have also become increasingly important.

3.9 Effective supervisory approaches

The review highlighted a number of different supervisory approaches that appear to havebeen more effective and are reflective of more advanced progress. One of the most effectivetools in advancing stress testing practices has been the significantly heightened focus onindustry-wide supervisory stress tests. Many countries found that this process has helpedfocus on common expectations, provide a structured approach for dialogue on better stresstesting practices, and identify gaps in banks' stress testing infrastructure. By challenging theloss results reported by banks on the prescribed scenarios, supervisors have motivatedbanks to justify their results and hence improve their internal assessment of key risk areas. Incontrast, there was some evidence that countries that have only conducted supervisory

stress tests or supervisory review of stress testing practices without leveraging these twoaspects together have not made as much progress in implementing the principles.

In addition, countries that address bank stress testing practices through the ICAAP reviewprocess have generally found this to be an effective mechanism, although periodic horizontalor thematic reviews that allow detailed comparison of practices across banks is a moreadvanced approach that is in use or under consideration in some countries. A formal self-assessment process conducted in some countries helped banks identify where theirpractices are consistent with the principles and where gaps exist in stress testingprogrammes.

Open dialogue with banks was also seen as a key element of an effective supervisory

programme. Annual meetings with banks can include discussions of risk developments andbest practices in stress testing that effectively create incentives for banks to strengthen their


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own practices. Another approach highlighted by some countries was to engage in dialogueon scenario selection, dynamics of models, reporting templates and data capabilities, andoverall robustness of the stress test at the highest level of bank management.

Several countries have issued publications describing observed good practices arising frombenchmarking or initial implementation reviews of the principles. This type of guidance allowsbanks to benchmark themselves against their local peers.

Banks, and to some extent regulators, are increasingly using stress testing as a means ofcommunicating their risk profiles to the market. However, disclosure requirements andpractices vary considerably by country. Many countries now publish aggregate summaries ofstress tests results in their regular financial stability reports, and in some cases outcomes forindividual banks. Some banks now routinely provide stress test results as part of theirfinancial results.

3.10 Future plans

Most supervisory authorities described future enhancements to their stress testingsupervision programmes. Those countries in the early phases of maturity are planning toissue, finalise or update rules on stress testing and to commence review and assessment ofstress testing practices. Some are also conducting supervisory stress tests for the first time.

Those supervisory authorities in intermediate to advanced stages of maturity plan to focus ondeepening their current on-site and off-site review programmes, with the aim of betterassessing how stress test outcomes are used in bank decision-making and risk appetitesetting. Stress testing results are expected to have a greater impact on contingency planningincluding recovery and resolution.

Additional supervisory work is planned for identifying and assessing how banks are

integrating stress tests results in the development of risk appetite and overall riskmanagement. Some supervisors will also use horizontal reviews across multiple banks toassess these areas as well as to benchmark banks internal stress test scenarios andassumptions. Greater focus on the use of stress test outputs in assessing capital adequacyand liquidity was evident in a few countries, with some also planning more explicitconsideration of stress test outcomes in setting capital buffers.

4. Principles for Banks

As the peer review focused on supervisory implementation, an assessment of stress testingpractices at banks was not within the scope of this review. Nevertheless, many countriesprovided high-level comments on progress of banks in their jurisdictions that werereasonably consistent and may be of broader interest.

In particular, all countries reported significant improvements in stress testing capabilities atbanks since publication of the principles. Authorities noted an overall improvement in therigor and quality of stress testing and the quality of information presented in ICAAPs.

Risk-specific stress testing, particularly regarding market and liquidity risk, was found to bereasonably well developed. More recently, banks have focused increasingly on centralised,firm-wide stress testing that encompasses a broader range of risks, but many countries notethis area is still evolving. Banks have strengthened their resourcing, with some banks nowhaving set up dedicated stress testing units.


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Banks are using a broader range of scenarios, including those that are more severe andcomplex. However, as noted below, many countries indicated that banks scenarios continueto be less severe than supervisors might find appropriate.

Banks generally are establishing stronger governance frameworks with clear lines ofresponsibility for stress testing, and some banks are giving more importance to stress testresults in their decision making. Some countries have seen an improvement in data systemsand ability to adapt to new vulnerabilities and specific scenarios. The level of documentationhas also improved.

Countries' responses to the review survey highlighted the following common areas of futureimprovement in bank stress testing practices.

Integrating results into decision-making . A number of countries pointed tochallenges banks have in incorporating stress test results into business andstrategic decisions. Stress testing tools are still immature and some countries feltthat in many cases the banks take a compliance-oriented approach in order to meet

regulatory requirements. Governance . There is a sense that banks need to have a better understanding of

stress testing limitations, assumptions, and uncertainties by users of stress testresults, including senior management and the board of directors.

Severity of scenarios . A number of countries saw a need for firms to deepen theseverity of scenarios. Supervisors in these countries remain concerned that banks'internal stress test scenarios do not plausibly reflect potential severe scenarios andoutcomes.

Data and IT infrastructure . A number of countries noted that data and IT systemsremain a key impediment to implementing effective stress testing programmes.

Accumulation of sufficient data for modelling purposes is a challenge for banks insome countries and aggregating information across the bank remains an issue.Generally, some manual intervention is needed to support the banks current IT anddata infrastructure to run regular stress tests.

Modelling issues . Translating and calibrating scenarios into stress outcomescontinues to be an area where banks' capabilities are challenged. Multiple risk classimpacts generally have not been modelled in a sophisticated manner, althoughsome banks attempt to take into account correlations between risks. Incorporatingfeedback effects and system-wide interactions remains very difficult. Anothertechnical area cited is the identification and aggregation of correlated risks andintegration between credit, market and liquidity risks.

5. Conclusions

The current environment has provided a sound test of how countries are putting into practicethe Committee's 2009 principles for stress testing supervision. There is clearly room forfurther progress among the supervisory community in the supervision of stress testing. Manycountries in the early to intermediate stages of implementation are working to finalise theirprudential requirements for stress testing and implement regular review programmes thatcover enterprise-wide stress testing governance, capabilities and models. Even thosecountries considered to be in the advanced phase of implementation of the principles felt thatthere are many remaining challenges with respect to their own stress testing programmes.


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Authorities are continuing with their efforts to embed the use of stress testing within theirsupervisory programmes. In many cases, this requires additional resources and training forboth generalist and specialist supervision staff. Stress testing infrastructure, including theability to collect appropriate data, develop models and aggregate results, continues toevolve.

Explicit consideration of stress test outcomes in assessing liquidity and market risk capitalrequirements is well established in supervisory frameworks. Stress testing has traditionallynot featured as prominently in assessment of overall bank capital adequacy but practices areevolving in this area.

The peer review has highlighted that there are different supervisory approaches and it isdifficult to state which is most effective. A combination of supervisory stress tests togetherwith involvement of generalist and specialist supervision staff in reviews of banks stresstesting practices at an enterprise-wide level often characterises the more well developedsupervisory programmes. More advanced countries are encouraging development of morerigorous practices at banks by conducting horizontal and thematic reviews, publishing the

results and providing feedback to banks. Finally, while the review found the principlesthemselves to be generally effective in setting high-level expectations, the Committee willcontinue to monitor implementation of the principles and determine whether, in the future,additional guidance might be necessary.

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Annex 1

BCBS Principles for Sound Stress Testing Practices and Supervision

BCBS Principles

1 Stress testing should form an integral part of the overall governance and risk managementculture of the bank. Stress testing should be actionable, with the results from stress testinganalyses impacting business decisions of the board and senior management. Board andsenior management involvement in the stress testing programme is essential for its effectiveoperation

2 A bank should operate a stress testing programme that promotes risk identification andcontrol; provides a complementary risk perspective to other risk management tools; improvescapital and liquidity management; and enhances internal and external communication.

3 Stress testing programmes should take into account of views from across the organisationand should cover a range of perspectives and techniques.

4 A bank should have written policies and procedures governing the stress testing programme.The operation of the programme should be appropriately documented.

5 A bank should have a suitably robust infrastructure in place, which is sufficiently flexible toaccommodate different and possibly challenging stress tests at an appropriate level ofgranularity.

6 A bank should regularly maintain and update its stress testing framework. The effectivenessof the stress testing programme, as well as the robustness of major individual components,should be assessed regularly and independently.

7 Stress tests should cover a range of risks and business areas, including at the firm-widelevel. A bank should be able to integrate effectively, in a meaningful fashion, across the rangeof its stress testing activities to deliver a complete picture of firm-wide risk.

8 Stress testing programmes should cover a range of scenarios, including forward-lookingscenarios, and aim to take into account system-wide interactions and feedback effects.

9 Stress tests should feature a range of severities, including events capable of generating themost damage whether through size of loss or through loss of reputation. A stress testingprogramme should also determine what scenarios could challenge the viability of the bank(reverse stress tests) and thereby uncover hidden risks and interactions among risks.

10 As part of an overall stress testing programme, a bank should aim to take account ofsimultaneous pressures in funding and asset markets, and the impact of a reduction inmarket liquidity on exposure valuation.

11 The effectiveness of risk mitigation techniques should be systematically challenged.

12 The stress testing programme should explicitly cover complex and bespoke products such assecuritised exposures. Stress tests for securitised assets should consider the underlyingassets, their exposure to systematic market factors, relevant contractual arrangements andembedded triggers, and the impact of leverage, particularly as it relates to the subordinationlevel in the issue structure.

13 The stress testing programme should cover pipeline and warehousing risks. A bank shouldinclude such exposures in its stress tests regardless of their probability of being securitised.

14 A bank should enhance its stress testing methodologies to capture the effect of reputationalrisk. The bank should integrate risks arising from off-balance sheet vehicles and other relatedentities in its stress testing programme.


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15 A bank should enhance its stress testing approaches for highly leveraged counterparties inconsidering its vulnerability to specific asset categories or market movements and inassessing potential wrong-way risk related to risk mitigation techniques.

16 Supervisors should make regular and comprehensive assessments of a bank's stress testingprogramme.

17 Supervisors should require management to take corrective action if material deficiencies inthe stress testing programme are identified or if the results of stress tests are not adequatelytaken into consideration in the decision-making process.

18 Supervisors should assess and if necessary challenge the scope and severity of firm-widescenarios. Supervisors may ask banks to perform sensitivity analysis with respect to specificportfolios or parameters, use specific scenarios or to evaluate scenarios under which theirviability is threatened (reverse stress testing scenarios).

19 Under Pillar 2 (supervisory review process) of the Basel II framework, supervisors shouldexamine a bank's stress testing results as part of a supervisory review of both the bank'sinternal capital assessment and its liquidity risk management. In particular, supervisorsshould consider the results of forward-looking stress testing for assessing the adequacy ofcapital and liquidity.

20 Supervisors should consider implementing stress test exercises based on commonscenarios.

21 Supervisors should engage in a constructive dialogue with other public authorities and theindustry to identify systemic vulnerabilities. Supervisors should also ensure that they have thecapacity and skills to assess a bank's stress testing programme.

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Annex 2

Indicators of maturity of BCBS principles implementation

The following criteria were considered by the review team to be indicative of an advanced level of stress testing supervision and implementation of the Committees principles forsound stress testing:

Final rules or supervisory guidance in place fully consistent with the Committeesprinciples as well as local sound practices.

Regular supervisor-mandated stress tests conducted by banks as well as bysupervisors and are not purely externally driven (eg FSAP).

Supervisory review includes targeted or thematic reviews of firm-wide stress testing

practices as well as risk-specific stress testing (eg market, liquidity risks). Supervisory review includes regular review of governance, infrastructure, models,

outcomes and scenarios.

Supervisory review programme is well resourced, involves experts as well asgeneralist supervisors with capability to challenge bank outputs.

Programme includes both on-site and off-site components.

Some expectations set for smaller banks.

Demonstration of stress testing leading to follow-up supervisory actions.

Detailed commentary in peer review questionnaire supports affirmative responsesand provides evidence of depth of expertise.

The following criteria were more indicative of an intermediate level of progress inimplementing the BCBS principles:

Rules or guidance may be in draft form or limited to restatement of the Committeesprinciples or Basel II requirements.

Review of firm-wide stress testing but primarily through annual ICAAP processrather than targeted or horizontal/thematic reviews.

Supervisory stress tests conducted including bank-run stress tests.

Occasional or limited review of stress testing governance, infrastructure andscenarios but little detailed review of models.

Some benchmarking and challenge of bank stress test scenarios and results bysupervisors but no systematic comparison of scenarios.

Supervisory review of stress testing may not generally lead to any outcome oraction.

Proactive plans to enhance supervisory programme.

Peer review questionnaire response provides some commentary on bank andsupervisory practices.


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The following criteria were indicative of an early level of progress in implementing theCommittees principles:

Rules or guidance in draft form or yet to be issued. No rules or guidance issuedsince prior to 2009 or rules do not appear to cover most of the Committeesprinciples.

Stress testing requirements and regular supervisory review primarily limited tospecific risks (eg market, liquidity).

Supervisory stress tests not conducted, cover only specific risk shocks or portfoliosor are entirely externally driven (eg FSAP).

Little or no on-site or off-site review of bank stress testing governance,infrastructure, models or scenarios.

Minimal commentary in peer review questionnaire to support responses.

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